24 Apr China’s Bad Loans May Be 25% And Here’s Why The Number Doesn’t Matter

This month (April 2016) the media warnings about risk in China’s debt market grew shrill. Two weeks ago, the IMF declared China’s economic uncertainty a risk to advanced economies. A CNBC article yesterday reported China’s debt-to-GDP levels at 250%, which puts China in the same bracket as Europe and the U.S., and higher than average for many emerging economies. Just hours ago, FT’s Tom Mitchell explained why the “bad bank” strategy that worked in the 1990s cannot be replicated today and raised again the specter of a looming NPL problem. Even Arthur Kroeber, a longstanding China bull, threw his hat into the ring last week when he compared China’s future trajectory to Japan’s recent past. Time to pile in. If I synthesize a bunch of data points (Tom Mitchell’s statistics with Christopher Balding’s Alphaville argument last October, recent bank disclosures and past experience with impaired loans) my very rough projected NPL rate is 25% , with 34%on the outside. This is also in line with Charlene Chu’s (possibly conservative) 22% projection in January.

Here is how my numbers break out: Banks hold 40% of China’s debt. My bank NPL estimate rounds the CBRC “special category” loan estimate, 3.79%, up to 4%. I assume these loans are rolled over (2.5x adjustment). The sum of 40% x 4% x 2.5 is 4% . Nonbank NPLs are 60% of China’s debt. Most likely they, too, will be rolled over wherever possible but it’s too hard to create a follow-the-money scenario, so I write them off. Simplistically, if the loans are worth 65% of face, nonbanks contribute 21% , for a total of 25% (Expected).

Or, in a much worse case that is still consistent with everything we know about impaired collateral in a crisis, they may be worth as little as 35%. The average of the two (50%) gives a nonbank impairment rate of 30%(60% x 50%), and puts total NPLs at 34% (High End) . Note that my approach blurs an important distinction between loan count and valuation. It is admittedly very rough.

But, bottom line, China has an NPL problem. Get over it , says the rude analyst. The obsession is unhealthier than the problem. Why? The answer should be obvious when we consider the lengths to which the U.S. Federal Reserve went to avoid contagion in 2009. Consider, too, that the U.S. unlike China had a mature bank deposit insurance scheme. China is actively managing a very complicated situation. At the same time, there is a silver lining to putting realistic NPL numbers out there. In the U.S., the Government Accountability Office (GAO ) did this but only in 2013. Delaying the disclosure of bad news is a mistake. It creates a rational anxiety that numbers are being lowballed. Having a defensible ballpark measure alleviates anxiety, enabling people to focus on what really matters: how China is putting its NPLs behind it and moving forward.